Basic option strategies

What this lesson explains and for whom

This lesson organises the basic option strategies — long call, long put, covered call, protective put, and vertical spread — and shows how to calculate the break-even threshold, maximum loss, and the number of contracts that fit the risk budget for each of them. It is for a reader who already knows what a premium is and how to read the Greeks, but does not know which structure to start with and how to translate it into a concrete amount in dollars. All numbers in the examples are illustrative, and broker-dependent values — multiplier, commissions, deposit — are worth confirming in the contract specification.

Strategy map: four structures instead of forty names

The order below is not accidental: each next structure adds one new element — ownership of the underlying, a second leg, management over time. Jumping straight to the most complex structure makes it hard to establish which element is responsible for the result.

Long call and long put

A directional position with risk limited to the premium paid plus transaction costs. Theta and implied volatility can eat the profit from a correct direction. It is the simplest way to learn the P/L diagram and delta. Before you calculate that diagram, make sure you understand the mechanism itself: strike, premium, and multiplier are described in the lesson What is an option.

Covered call

Stock plus a written call. The premium adds to the result, but the gain from the underlying itself ends at the strike level. The structure requires owning the stock — it is not a source of free money.

Protective put

Stock plus a purchased put, that is, insurance. It costs a premium and worsens the result in a sideways trend, but it sets the worst case for the whole position in advance.

Vertical spread

Buying and selling options of the same type at different strikes. It cuts the entry cost and defines both maximum profit and maximum loss. For most people starting out, this is a better next step than a naked short.

Arithmetic: premium, break-even, and maximum loss

Without these formulas, two strategies cannot be compared, because a large profit and small risk are impressions, not numbers.

long call:   break-even (on expiry day) = strike + premium paid
long put:    break-even (on expiry day) = strike − premium paid
max loss long call / long put = premium × multiplier × number of contracts

vertical debit (for example bull call spread):  debit = premium bought − premium sold
max loss = debit × multiplier × number of contracts
max profit = (higher strike − lower strike − debit) × multiplier × number of contracts
break-even = lower strike + debit

vertical credit (for example bear call spread):  credit = premium sold − premium bought
max profit = credit × multiplier × number of contracts
max loss = (higher strike − lower strike − credit) × multiplier × number of contracts
break-even = lower strike + credit

covered call:  stock break-even = purchase price − premium received
max profit = (strike − purchase price + premium received) × number of shares

number of contracts = (capital × risk per trade) / (premium × multiplier × currency rate)

The multiplier depends on the market and the instrument. On local and foreign markets, check it with your broker before calculating position size, and remember that premiums quoted in a different currency must be converted at the account rate.

Example (illustrative numbers): buying a call with strike 100 for 3.00 and selling a call with strike 105 for 1.20 gives a debit of 1.80. With a multiplier of 100, maximum loss is 180, maximum profit is (105 - 100 - 1.80) x 100 = 320, and break-even is 101.80. In the credit version, the same two strikes swap roles: the credit of 1.80 is the maximum profit, and 320 is the maximum loss. All quantities follow from the same inputs — and all of them must be known before clicking.

How many contracts to buy: position size calculated from the premium

When buying an option, the maximum loss is known in advance, so it is what sets position size. The order of operations:

1. Set risk per trade as a percentage of capital. The starting point is 1-2% — an illustrative frame discussed in the 1-2 per cent rule lesson.
2. Convert the percentage into an amount: capital x adopted percentage.
3. Divide that amount by (premium x multiplier), after converting the premium to dollars at the account rate.
4. Round the result down to whole contracts. If it comes out to zero, the position is too large for that capital, not almost one.
5. Check that maximum loss does not exceed the daily loss limit from the daily limit and drawdown lesson.

In debit spreads, you substitute the debit in place of the premium, and then maximum loss equals the entry cost. In credit spreads, you calculate the maximum loss of the whole structure, not the credit received — those are two different numbers.

Table to fill in: your numbers for each strategy

Complete it for the instrument you actually watch. Enter amounts in dollars after converting at the account rate.

If you cannot enter a number in any of the cells, the strategy is not yet ready for entry. What is missing is data, not courage.

Risk comparison (educational)

Risk that is undefined in a naked short position is not an advanced income strategy — it is the absence of a loss limit. The margin blocked by the broker is also not a risk budget: it is collateral calculated on the broker’s side, which can be increased when volatility rises.

Learning order and selection protocol

1. Read the P/L diagram on expiry day and now for each structure you consider.
2. Trade long premium in small position size, where 1R is the premium paid.
3. Add a vertical with a known maximum loss.
4. Only after several dozen closed transactions consider short premium — always in a spread version, never naked.

Exiting a position is described in the lesson on managing an option position, and premium pricing in premium and pricing.

If a broker offers CFD options or binary options, read the agreement separately. That is a different product from an exchange-traded option with a multiplier and settlement through a clearing house. This course assumes a classic option chain and a defined maximum loss.

When a strategy says do not trade

1. You do not know the maximum loss in dollars. If you cannot calculate it from the premium and multiplier, you know hope, not risk.
2. Position size exceeds 1R. A contract count rounded up so that the position makes sense is a change of rule at the moment you make the decision.
3. The structure requires owning the underlying and you do not own it. A covered call without stock is in practice a naked call sale, with a completely different risk profile.
4. You cannot see the premium, multiplier, and deposit in one place in the platform. Missing data is not an opportunity, it is a reason to postpone entry and confirm the terms with your broker.

Common mistakes in choosing a strategy

• Choosing a strategy for its potential profit without checking maximum loss — a vertical and a naked short look similar until both profiles are calculated.
• A covered call without a plan for a fall in the stock — the option premium does not protect against a larger decline in the underlying.
• Copying a strategy from the internet without testing on a demo account — different broker, different chain liquidity, different result in practice.
• Opening several different strategies at once at the start — it is then hard to establish which element of the plan actually works.
• Treating break-even as the price from which profit begins, without commissions and spread — entry and exit cost shift the threshold materially, not cosmetically; see round-trip cost.

Measurable exercise

For a long call and a bull call spread on the same instrument (demo account), perform four steps: record the premiums and strike levels, calculate break-even plus maximum profit and loss from the formulas in this lesson, convert maximum loss to dollars at your multiplier and rate, and finally record it as a percentage of capital and check whether it fits within 1R. Complete the table from the lesson. Goal: two P/L diagrams and two maximum loss amounts, without opening a naked short.

Common questions

Is a covered call safe?

It limits the gain on the stock to the strike and does not fully protect against a fall in the underlying. It is a way to manage a block of shares you already own, not risk-free income. Maximum loss here is calculated from the stock purchase price, not from the premium.

When may I think about a naked short?

Only once you can calculate maximum loss, have an exit rule, and have experience with spreads that carry defined risk. In a starter course the answer is: no. The deposit blocked by the broker is not a loss limit.

How many strategies should I master in the first month?

One long structure and one vertical. A list of forty names without a P/L diagram and without position size is an illusion of competence that does not protect the account.

Why calculate break-even and maximum loss when the market decides the result anyway?

Because the market decides the result of a single transaction, while these two numbers decide whether it is worth opening at all and with what size. Without them you cannot tell a strategy with 320 profit and 180 risk from one with a similar chart but unlimited loss. Measurement turns a decision into a comparison of two concrete amounts, and only such a comparison can be repeated and settled in a journal.